Commodity price risk management: when to hit the brakes

You’re hitting the road for your daily commute. Driving can be risky and you want to arrive safely at your destination. You consider yourself a careful driver and you’ve adopted a strategy of maintaining 50% braking force for the entire journey.

Wait, what? Nobody drives like that.

On open road, risks are low so as long as you pay attention and are ready to brake, you don’t need any braking most of the time. Maintaining 50% braking in these conditions will just slow you down and cost you money. Other times, there is traffic ahead or a risk presents suddenly – a car cutting into your lane – which calls for more aggressive braking, even a full stop. In these cases, 50% braking is not enough.

The level of risk in the driving environment is constantly changing. Braking is a key risk management tool, and drivers know intuitively to use more or less risk management, in response to more or less risk in the environment. At the end of your commute, you arrive at the office, where the task of managing your commodity price risk awaits you. What strategy are you going to use?

Some energy buyers will say “We are conservative, so we want to be 50% hedged all the time.” But we know as drivers that uniform application of your risk management tools in all conditions is bound to be wrong almost all the time – either too much or too little, but hardly ever just the right amount. And even then, only by chance.

We need a commodity price risk strategy that is risk-responsive. More risk management when risk is high, less (or even none!) when risk is low. That is how we achieve the optimum balance of risk reduction and cost reduction. Let’s think about what a risk-responsive commodity price risk management strategy would look like.

A pithy and powerful definition of “risk” comes from the International Organization for Standardization (ISO): Risk is the impact of uncertainty on objectives. Just the presence of uncertainty is not enough for there to be risk. There is risk only if the uncertainty is significant enough to have a material impact on the organization’s ability to achieve its objectives. Uncertainty that has no potential material impact is just noise.

Looking at energy price risk through this lens sets the organization up with two key questions to ask:

• What degree of energy price change would have a material impact on us?
• How likely are we to experience that degree of energy price change under current conditions?

The first of these questions is introspective. Each organization must assess for itself its own risk tolerance. The answer will vary depending on the business the organization is in, its financial position, even its own culture and attitude toward risk. In Jupiter’s experience, it is imperative to involve senior management and representatives of various functional areas in arriving at an answer – and in fact an understanding – around this question.

Note here that the degree of risk I face is unique to me because it depends on the risk tolerance that is particular to my organization. No one can tell me what risk management measures my organization should be taking unless they first understand my organization’s tolerance for risk. There is no “one size fits all” risk management strategy recommendation.

The second question involves looking out at market conditions. But this market analysis is not about trying to divine the future path of prices. Prices are uncertain, and risk is about that uncertainty. The amount of uncertainty in prices is exactly what we need to measure to assess risk. Pretending someone can foretell where prices are going simply assumes away the problem!

There are sound analytical techniques that enable us to determine a confidence level around a range of possible future price outcomes. We don’t know what the price will be, but we can be 90% sure it will be less than X or greater than Y. The level of price risk in the market changes over time, just like the risk in traffic changes at different points along our journey, so we need to measure risk continuously.

Importantly, risk is about the potential magnitude of price changes, not about the current level of prices or even the current price trend. A low-price market can be a high-risk market, so we should not be sanguine simply because prices are low.

Effective risk management is not about trying to lock in at a target price or divine fundamental and technical indicators to spot the bottom or predict the timing of a market turn. It comes down to:

• Identifying what range of pricing outcomes are unacceptable to your organization
• Establishing a confidence level we want to maintain that we will avoid unacceptable price changes
• Applying analytical methods to quantify the amount of risk in the market from time to time.

With our tolerance for risk in mind and analysis that quantifies the price risk that lies in front of us, we’ll know when and how aggressively to respond to it, exactly the way a driver knows when and how hard to hit the brakes.

We do risk management this way every day on the way to work. We just need to continue to do it once we get there.